The effects of a Middle Class Income Tax Reduction on the Canadian Economy

Chevy Rennie and Michael Johnson

130140740 and 130222910

EC 313A

Professor Mortazavi

Executive Summary:

After a bold campaign slogan, “Real change for the middle class”, Justin Trudeau and his

majority Liberal government have many promises to live up. The most dominant of which is his

pledge to cut taxes for the middle class of Canada. According to Trudeau, families should see

this impact almost immediately, and the value is to be significant; up to $1,340 per year for a

dual-income family (Geddes, 2015).

While the middle class enthuses over their potential financial gains, Canadians with incomes

over $200,000 are expected to bear the burden of the tax cut with a rate hike from 29 percent

to 33 percent (Maclean’s, 2015). According to a preliminary Maclean’s article, the higher tax

bracket is expected to cover the entire $3 billion needed to pay for the middle bracket

(Maclean’s, 2015).

After conducting multiple regression analyses, we’ve concluded that the middle income tax cut

will not significantly affect Gross Domestic Product in Canada. As well, the tax break to the

middle class will lead to a decrease in tax revenue collected by the Federal Government

resulting in a substantial increase in the deficit.

Finally, highlighting a more non-statistical point, the tax cut is not expected to express much

change in personal consumption or GDP for at least a year. Although the Trudeau government

expressed an urgency and promised an immediate change in an individual’s income taxes,

Canadians will need to wait personally for their break. As for the effects on GDP and Canadian

consumption, there will be a more prolonged result, which is at the discretion of the current

multiplier.

Abstract:

What are the impacts of a middle income tax cut on the Canadian economy? This research

paper will take a statistical approach determining the effects of the Liberal Government’s

reduction of middle class income taxes. This middle class tax reduction will increase the middle

20% of income share and decrease the Gini Coefficient for Canada based on regression results,

thereby reducing inequality (“Canada”). However, the middle class tax cut has a statistically

insignificant correlation with GDP. And, this middle class tax cut will lead to a decrease in tax

revenue, which will be one of the causes of an increase in the Federal Government deficit to

$25 billion based on statistics from National Bank (Tencer, 2016).

Introduction:

The Canadian Federal Election took place on October 19th, 2015; which resulted in the Liberal

Party winning a majority government, holding 184 seats in the House of Commons (“Current

Party Standings,” 2016). Justin Trudeau’s election platform contained policies such as reducing

the marginal tax rate for incomes between $44,700 and $89,401 from 22% to 20.5% (“Middle

class tax,” 2016). This will be the focus for all statistical inference throughout the article. This

policy was created in order to decrease income inequality throughout Canada, thereby

increasing the after-tax incomes of middle-income people, which would increase their

consumption in the economy. And, the Liberal Government has a policy of increasing the

marginal tax rate from 29% to 33% for earnings above $200,000 per year (“Middle class tax,”

2016). The increase in the tax rate for incomes over $200,000 would decrease the amount of

consumption spending by these income earners (“Middle class tax,” 2016).

Literature Review:

Article: “The truth about Justin Trudeau’s tax cuts” (Geddes, 2015).

In this article, the $3 billion generated from raising the marginal tax rate from 29% to 33% for

incomes higher than $200,000 will pay for the middle class marginal income tax rate reduction

(Geddes, 2015). This revenue-neutral plan will be beneficial for the Federal Government in

terms of financial solvency. Economist David Macdonald, studied the income effects of this tax

change and found that this tax reduction for the middle class will provide higher financial

benefits to people with higher incomes, through determining that $51 would be saved per year

for incomes between $48,000 and $62,000, while $817 would be saved each year for incomes

between $166,000 and $211,000 (Geddes, 2015). This is an issue because wealthier individuals

will have higher net benefits from this middle class marginal tax rate reduction. The Liberal

Government intended to decrease inequality through this middle class income tax cut, however

through economic research, wealthy individuals benefit more than low income individuals.

Article: “Liberal government passes “middle-class” tax cut” (Fitz-Morris, 2015).

NDP Leader Thomas Mulcair stated that people with incomes near $200,000 will have the

largest net benefits from the tax reduction for the middle class (Fitz-Morris, 2015). Since people

with incomes near $200,000 have the highest net benefits from this tax change, this tax change

is not performing what is intended because the Liberal Government was trying to reduce

income inequality through a reduction in middle-income taxes (Fitz-Morris, 2015). Also, the

Canadian Finance Minister Bill Morneau stated that this middle income tax reduction will need

debt-financing of $1.2 billion (Fitz-Morris, 2015). This debt-financing is negative for the

Canadian Federal Government because it will increase the deficit beyond the projected $10

billion during the election campaign (Fitz-Morris, 2015). However 230 MPs voted to implement

the tax cut for the middle-class, while 95 voted against this measure (Fitz-Morris, 2015). The

NDP voted for this tax reduction for the middle-class, and the Liberal Caucus did as well. Former

Prime Minister Stephen Harper voted against this middle class tax reduction.

Article: “Taxes for high earners to increase January 1st, 2016: Act now to save!” (Safar, 2015).

PWC recommends to receive all rent proceeds, capital income, RRSP income, and RRIF earnings

in 2015 if earnings exceed $200,000 in order to avoid the 2016 marginal tax increase from 29%

to 33% for incomes over $200,000 (Safar, 2015). However, people with incomes between

$44,700 and $89,401 should receive all earnings from capital, work, and properties in 2016 in

order to take advantage of the decrease in the marginal tax rate from 22% to 20.5% (Safar,

2015). These clever tax strategies can reduce the tax burden for people throughout Canada.

These strategies were recommended after the October 19th, 2015 election because the middle

class income tax reduction and upper class income tax increase were election platforms for the

Liberal Party (Safar, 2015). Also, people should contribute more to their RRSPs and pay more

childcare expenses in order to have deductions to their taxable income, therefore they could

potentially reach the tax bracket of $44,700 and $89,401 (Safar, 2015).

Article “On The Edge: Declining Marginal Utility and Tax Policy” (Lawsky).

Lower taxes for low incomes will have a higher marginal utility increase than lower taxes for

high incomes, therefore middle income tax cuts should occur because a pareto improvement

would result. Also, increasing taxes for high incomes is more efficient than increasing taxes for

low incomes due to the smaller marginal utility losses for high incomes. Based on these

findings, taxes should be reduced for low incomes and taxes should be increased for high

incomes.

Methodology:

The data for this research is collected from the World Bank. The data consists of Canadian tax

rates, GDP, Gini Coefficients, and income shares. Regressions were performed to determine the

correlations between tax rates, inequality, and GDP.

Based on the regression that was performed with GDP as the output variable and the tax rate

for income/profit/capital gains, government spending, consumption by households, and

investment as the input variables, it was shown that the tax rate for income/profit/capital gains

has a negative correlation with GDP, therefore if this tax rate decreases, GDP will increase

holding all else constant (“Canada”). However, the t-statistic for the tax rate for

income/profit/capital gains coefficient is -1.18, which shows that it is not statistically significant

at the 5% significance level because the t-statistic is larger than -1.96 (“Canada”). And, the p-

value for the tax rate for income/profit/capital gains coefficient is 0.255, which is not

statistically significant at the 5% significance level because it is higher than 0.05 (“Canada”).

Therefore based on the t-statistic and p-value showing that the tax rate coefficient is not

statistically significant, this shows that the tax rate and GDP have a weak negative relationship.

Based on this weak negative relationship, it is less likely that a tax rate decrease will grow the

economy, governments should take this into account to make policy for their nations.

Furthermore, the government spending coefficient has a t-statistic of -3.58, the consumption

coefficient has a t-statistic of 7.24, and the investment coefficient has a t-statistic of 3.99, which

are all statistically significant at the 5% significance level (“Canada”). Therefore, government

spending, consumption, and investment have strong correlations with GDP because their

coefficients are statistically significant. Also, the R^2 is 0.9995 for this model, which shows that

the model explains 99.95% of the variation of the data, this is important because only 0.05% of

the model is unexplained (“Canada”). Moreover, the F-statistic for this model is 9461.90, which

is considerably higher than 0, which shows that the model is jointly significant, which leads to a

lower amount of unexplained variation in the data (“Canada”).

The regression in Appendix 2 shows that the Gini Coefficient has a positive correlation with the

tax rate for capital gains/income/profit from 1991 to 2010 (“Canada”). The coefficient for the

tax rate variable is 0.447165, therefore the Gini Coefficient increases by 0.447165 per 1%

increase in the tax rate, holding all else constant (“Canada”). This shows that tax increases can

lead to higher inequality based on this model, and tax decreases lead to less inequality. The

Canadian Government’s tax rate reduction on the middle class will reduce inequality based on

this regression. Also, the t-statistic for the tax rate coefficient is 4.41, which is statistically

significant at the 5% significance level because it is greater than 1.96 (“Canada”). Also, the p-

value is 0.005, which is statistically significant at the 5% significance level because it is less than

0.05 (“Canada”). Also, the R^2 is 0.7645, which shows that the model explains 76.45% of the

data’s variation (“Canada”). Based on this, 76.45% of the Gini Coefficient results are explained

by the tax rate changes, shown through this regression (“Canada”).

Appendix 4 shows a regression of the income share for the middle class (middle 20 percent of

incomes) and the tax rate on capital gains/income/profits. The coefficient on the tax rate

variable is -0.0776821, which shows that there is a negative correlation between the tax rate

and the income share for the middle 20 percent of incomes (“Canada”). Based on this model,

there is a 7.77% increase in income share for the middle 20 percent of incomes per 1%

decrease in the tax rate, holding all else constant (“Canada”). Using this model, the Federal

Government’s tax cut for the middle class will increase the middle class share of income, which

would reduce income inequality. This would be positive for the Canadian economy because

there would be more fairness for incomes. Also, the t-statistic is -2.40, which is less than -1.96,

and this makes the coefficient statistically significant at the 5% significance level (“Canada”).

Therefore, this negative correlation between income share of the middle 20 percent and tax

rates is a strong relationship based on the statistical significance of this relationship, which

shows that middle class tax rate reductions can be used consistently to reduce inequality.

The middle class income tax decrease from 22% to 20.5% will decrease government revenue by

$4.5 billion dollars (“Canada”). However, the increase in the marginal tax rate from 29% to 33%

will increase government revenue by $7.36 billion dollars (Commisso, 2016). Therefore, the two

tax rate changes will increase the government surplus by $2.86 billion (“Canada”). If the

government wanted to make the middle class tax cut revenue neutral, the government would

need to raise the marginal tax rate for incomes over $200,000 by 3.24% (Commisso, 2016).

Conclusion:

Based on regression research, taxes and GDP do not have a statistically significant negative

correlation, therefore lower taxes do not cause higher GDP (“Canada”). However, the

regression of the middle class income share and the tax rate for capital gains/income/profit

show that inequality reduces when tax rates decrease, which can lead to more fairness. And,

the regression of the Gini Coefficient and the tax rate shows that a tax rate decrease leads to

less inequality. Therefore, the middle income tax reduction is likely to reduce inequality,

however it will not lead to increases in economic growth. Governments need to use middle

income tax reductions in order to reduce inequality in their nations.

Appendix 1: Regression of GDP, tax rate on capital gains and income and profit, government spending, household consumption, and investment.

(“Canada”)

Appendix 2: Gini Coefficient (percent) is the output and the tax rate on capital

gains/income/profits is the input variable (1991 to 2010)

(“Canada”)

_cons 9.659584 5.26481 1.83 0.116 -3.222942 22.54211

taxrate .447165 .1013112 4.41 0.005 .1992655 .6950646

gini Coef. Std. Err. t P>|t| [95% Conf. Interval]

Total 10.222398 7 1.46034257 Root MSE = .63338

Adj R-squared = 0.7253

Residual 2.40702335 6 .401170559 R-squared = 0.7645

Model 7.81537461 1 7.81537461 Prob > F = 0.0045

F( 1, 6) = 19.48

Source SS df MS Number of obs = 8

. regress gini taxrate

31

32

33

34

gin

i

48 50 52 54 56taxrate

Appendix 3: The income share of the lowest 10% as output and the tax rate on capital

gains/income/profits as the input variable (1991 to 2010)

(“Canada”)

_cons 4.642091 1.09887 4.22 0.006 1.953254 7.330928

taxrate -.0387298 .0211456 -1.83 0.117 -.0904714 .0130117

lowest10 Coef. Std. Err. t P>|t| [95% Conf. Interval]

Total .163487424 7 .023355346 Root MSE = .1322

Adj R-squared = 0.2517

Residual .104859378 6 .017476563 R-squared = 0.3586

Model .058628046 1 .058628046 Prob > F = 0.1167

F( 1, 6) = 3.35

Source SS df MS Number of obs = 8

. regress lowest10 taxrate

2.4

2.5

2.6

2.7

2.8

low

est1

0

48 50 52 54 56taxrate

Appendix 4: The income share of the third 20 percent (middle 20 percent of earnings) as the

output and the tax rate on capital gains/income/profits as the input variable (1991 to 2010)

(“Canada”)

_cons 21.05948 1.682164 12.52 0.000 16.94338 25.17559

taxrate -.0776821 .03237 -2.40 0.053 -.1568887 .0015245

third20 Coef. Std. Err. t P>|t| [95% Conf. Interval]

Total .481587239 7 .068798177 Root MSE = .20237

Adj R-squared = 0.4047

Residual .245726122 6 .040954354 R-squared = 0.4898

Model .235861117 1 .235861117 Prob > F = 0.0533

F( 1, 6) = 5.76

Source SS df MS Number of obs = 8

. regress third20 taxrate

16

.616

.817

17

.217

.4

third

20

48 50 52 54 56taxrate

Appendix 5: The income share of the highest 10% as the output and the tax rate on capital

gains/income/profits as the input variable (1991 to 2010)

(“Canada”)

_cons 4.957648 4.330465 1.14 0.296 -5.638617 15.55391

taxrate .3853279 .0833315 4.62 0.004 .181423 .5892328

highest10 Coef. Std. Err. t P>|t| [95% Conf. Interval]

Total 7.43178546 7 1.06168364 Root MSE = .52097

Adj R-squared = 0.7444

Residual 1.62848557 6 .271414261 R-squared = 0.7809

Model 5.80329989 1 5.80329989 Prob > F = 0.0036

F( 1, 6) = 21.38

Source SS df MS Number of obs = 8

. regress highest10 taxrate

23

.524

24

.525

25

.526

hig

hest1

0

48 50 52 54 56taxrate

References:

Blatchford, A. (2015, December 7). Liberals Admit Middle Class Tax Cut Not Revenue-Neutral.

Retrieved January 29, 2016, from http://www.huffingtonpost.ca/2015/12/07/liberals-middle-

class-tax-cut-rich_n_8740118.html

Canada. (n.d.). Retrieved February 24, 2016, from http://data.worldbank.org/country/canada

Commisso, C. (2016, November 3). Canada's richest 1% earned average income of $454,800 in 2013. Retrieved March 8, 2016, from http://www.ctvnews.ca/canada/canada-s-richest-1-earned-average-income-of-454-800-in-2013-1.2640352 Current Party Standings. (2016, February 22). Retrieved February 24, 2016, from

http://www.parl.gc.ca/parliamentarians/en/partystandings

Fitz-Morris, J. (2015, December 10). Liberal government passes 'middle-class' tax cut. Retrieved

January 29, 2016, from http://www.cbc.ca/news/politics/house-passes-liberal-tax-plan-

1.3357143

Geddes, J. (2015, November 05). The truth about Justin Trudeau's tax cuts. Retrieved January

29, 2016, from http://www.macleans.ca/politics/ottawa/the-truth-about-justin-trudeaus-tax-

cuts/

Gordon, S. (2012, September 10). Why economists love consumption taxes. Retrieved January

24, 2016, from http://www.theglobeandmail.com/report-on-business/economy/economy-

lab/why-economists-love-consumption-taxes/article1381083/

Lawsky, S. (n.d.). On The Edge: Declining Marginal Utility and Tax Policy. Retrieved March 8,

2016, from http://www.law.uci.edu/faculty/full-time/lawsky/OntheEdge.pdf

Middle class tax cut. (2016). Retrieved January 24, 2016, from

https://www.liberal.ca/realchange/middle-class-tax-cut/

Safar, J. (2015, December 7). Taxes for high earners to increase January 1st, 2016: Act now to

save! Retrieved February 24, 2016, from https://www.pwc.com/ca/en/tax-

insights/publications/pwc-taxes-high-earners-increase-january-1-2016-2015-12-en.pdf

Tencer, D. (2016, January 27). Ottawa Will Run $50 Billion In Deficits In Next 2 Years: National

Bank. Retrieved January 29, 2016, from http://www.huffingtonpost.ca/2016/01/27/deficit-

forecast-canada_n_9088724.html?ncid=tweetlnkcahpmg00000002